What the German elections mean for Europe

Extract research paper by Martin Lueck - UBS Investment Bank 9th September 2013

 

What the German elections mean for Europe

So if Mrs Merkel remains in power, what does it mean for Germany’s stance on
Europe? Numerous discussions with investors in different parts of the world
suggest that there are two camps out there. One camp is expecting the German
government to switch back to austerity mode after the election. This camp
basically believes that Germany’s recent move towards a more lenient position
was just election posturing, and that Berlin’s call for tough reform will resume
after 22 September. We think this view is wrong. The impression we are getting
from conversations with policy makers over the recent past is that their
assessment of the euro crisis has rather changed for real, in the sense that there is
now a genuine understanding that austerity alone will not be enough to remove
existing imbalances. If our impression is correct, it is, hence, very unlikely that
the government switches back to tough austerity language after the election.The
other camp thinks that upon entering her third term as chancellor, Mrs Merkel
will start looking for her place in history books and will therefore turn softer on
the periphery. While we agree that the chancellor is eager to one day go down in
history as the one who saved the euro, rather than the one who tore it apart,
it will be in Merkel’s best interest to continue weighing off any German commitment
against the request for reform in debtor countries. This quid pro quo strategy has
 been extremely successful. It has created the basis for Merkel's reputation as a
good manager of the euro crisis. In fact, polls suggest that even a huge majority
of SPD followers believe that the task of saving the euro is in good hands with
the chancellor.

So what happens if the SPD comes in? First, in the unlikely yet possible case

that an SPD/Greens coalition takes over, many financial markets participants
would likely expect the German stance to soften significantly. However, the
SPD, who used to promote eurobonds until late 2011, is no longer openly
advocating positions that are highly unpopular among German voters. Apart
from eurobonds, this is burden-sharing in a banking union (often referred to as
‘debt mutualisation through the backdoor’ in Germany), as well as too moderate
a stance on fiscal adjustment and structural reform. As a consequence, the SPD
would not be able to move away, at least not by much, from Merkel’s policy
stance, because otherwise it would get punished by German voters right away.
This is why we believe that even a change in government would hardly change
Germany’s position on Europe, at least not by much. A less dramatic change
towards SPD participation, ie, the SPD joining Merkel’s CDU as a junior
coalition partner, would hardly dilute the centre-right’s euro bias at all. As a
result, even with the SPD in government (in the driver’s seat or as junior
partner), Germany’s role would not change either.

Yet this does not mean that for financial markets this kind of outcome would be
a non-event. On the contrary, we think that in the case of SPD participation in
the new government, many investors would expect a softening of Germany’s
stance. As a result, most likely peripheral spreads would come down, risk assets
outperform and the euro exchange rate depreciate. However, as we believe that
expectations would be built on shaky ground in that case, we would expect a
counter-reaction somewhat later on, once investors realise that their expectations
regarding the SPD were too sanguine. In that event, the election would at least
create some volatility, with asset prices back at their pre-election levels at the
end of the process.

To sum up: We do not think that the German election is a done deal yet. Many

voters are undecided, and unexpected events can still change the outcome.
However, from today’s perspective, it looks very likely that Mrs Merkel will
remain in office, probably even in a coalition with her preferred partner,
liberalist FDP. Against this backdrop, we think those expecting big changes in
Germany’s stance on the European crisis after the election will be disappointed.
Participation of the SPD might provoke even more hopes, and some volatility in
financial markets, which would most likely be disappointed later on. In this
sense, the election does not look like a non-event at all.